Infectious Greed (51 page)

But in context, the e-mails made Merrill look even worse. Consider the “Going to 5” comment about Internet Capital Group. Merrill had maintained a positive 2 rating for Internet Capital Group and kept the stock on its “top-ten” list of technology stocks, even though Henry Blodget was predicting privately that “there really is no floor to the stock.”
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But as the stock's price fell from $200 to $15, Blodget was upset by the pressure to maintain a high rating, and he threatened to start “calling the stocks like we see them, no matter what the ancillary business consequences are.”
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Or consider the “piece of junk” and “powder keg” comments about InfoSpace, which Merrill rated a 1-1. Blodget was pressured to maintain the high rating even as InfoSpace's stock fell 80 percent, and Blodget expressed “enormous skepticism” about the stock and complained that “I'm getting killed on this thing.” Why? InfoSpace was planning to buy another Internet company, Go2Net, for more than a billion dollars, and Merrill—which represented Go2Net—would earn substantial investment-banking fees from the deal. After the deal was done, Blodget finally reduced his rating.

Perhaps the most damning example—in context—was Merrill's coverage of
GoTo.com
, an Internet search company now known as Overture Services, Inc. In 1999, Merrill lost its pitch to do GoTo's IPO, and Merrill's analysts did not issue a rating for GoTo's stock. In 2000, Merrill again solicited investment-banking business from GoTo, and dangled a stock rating from Henry Blodget as a carrot. In September 2000, GoTo finally agreed to give Merrill some business, arranging for a European deal, and Merrill promised that Blodget would begin covering GoTo. When a fund manager asked Blodget, “What's so interesting about GoTo except banking fees?” Blodget responded, “Nothin'.”
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It would have been very time consuming for Merrill to prepare its initial research report on the company from scratch, so GoTo executives supplied the data and comments, and actually typed changes into the
draft report. They even supplied the full text of particular sections. When Kirsten Campbell, a junior Merrill research analyst, questioned whether GoTo would become profitable before 2003, and suggested it deserved only a 3 rating, she became embroiled in a dispute with GoTo's executives, who argued that the company would become profitable in 2002 and deserved a 2 rating. Campbell e-mailed Blodget that she did not “want to be a whore for f-ing management” of GoTo.

A decade earlier, Campbell would have been respected for her interest in ensuring an accurate rating. But in 2000, she was merely causing trouble by raising concerns: “We are losing people money and I don't like it. John and Mary Smith are losing their retirement because we don't want Todd [Tappin, GoTo's chief financial officer] to be mad at us.” No one wanted to hear Campbell's complaints that “the whole idea that we are independent from banking is a big lie.”
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And no one supported her opinion that GoTo should be rated 3-2 at the highest.

Meanwhile, GoTo's stock had fallen below $10 a share. There was a brief circus as Merrill—which was prohibited by law from issuing new ratings on stocks with a price below $10—tried to decide what to do. Blodget, showing off his Yale education, said, “Waiting for $10 is waiting for Godot.” On January 10, the price briefly hit $10, and Blodget immediately announced coverage of GoTo at a rating of 3-1, higher than Campbell had recommended.

Campbell left Merrill a few months later and, after she left, Blodget upgraded GoTo to a 2-1, and the stock rose 20 percent. Blodget then joined a group of investment bankers sponsoring a road show for a new stock issue GoTo was planning. Merrill hoped to be named lead manager for the deal, which would mean substantial investment banking fees.

When GoTo indicated it was leaning toward CS First Boston and Frank Quattrone, instead of Merrill, Blodget was irate. He immediately began preparing to downgrade GoTo from the rating of 2-1. A Merrill banker complained, “Not only did Henry Blodget show leadership by initiating on the stock near its low point but he recently upgraded it and sponsored a set of investor and Merrill sales force meetings for management in New York, which dramatically moved the stock price.” One of Blodget's assistants began drafting a memorandum explaining that Merrill was downgrading the stock
on valuation,
meaning that the price had risen too much (he noted that “I don't think I've downgraded a stock on valuation since the mid-90's”). The downgrade was held in reserve until GoTo decided who to name as lead manager for its offering. During the
morning of June 6, 2001, GoTo filed its stock-offering documents, listing CS First Boston as lead manager. A few hours later, Henry Blodget issued a notice that he was downgrading GoTo to a 3-1.

Blodget left Merrill a few months later, with a severance package reportedly worth $2 million.
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Merrill ultimately agreed to pay a $10 million fine and to reform its approach to research. But many major investment banks and analysts continued to assert that their high ratings may have been wrong in hindsight, but were perfectly legal. For example, Mary Meeker, the Morgan Stanley analyst, had not been accused of any wrongdoing and continued to receive big bonuses for 2002 (although perhaps not the eight-figure bonus she had received at the peak of the Internet boom).

 

 

T
he final group of people profiting from the technology bubble was the most obvious: corporate executives. CEOs in 1999 were no different from CEOs a few years earlier, and all responded to the incentives created by earlier changes in law. Executive compensation rules continued to encourage stock-option grants, and CEOs with millions of options sought to increase share prices in the short run, even if they knew their actions jeopardized the long-term health of their companies. Likewise, limits on securities lawsuits continued to insulate executives, and their accountants and bankers, from liability. Not surprisingly, technology firms aggressively manipulated their financial statements, just like their predecessors at Cendant, Sunbeam, Waste Management, and Rite Aid.

There were numerous “new-economy” examples of fraud allegations, ranging from Lernout & Hauspie to W. R. Grace, from Livent to Yahoo!, from Lucent to Navigant, from MicroStrategy to Xerox. But the stories were essentially the same. To the extent the problems at these companies differed from previous frauds, SEC lawyers tried to put the problems within one of the simple categories of fraud SEC chair Arthur Levitt had outlined in his 1999 “Numbers” speech.

Consider MicroStrategy Inc., one of the many high-flying companies that did an IPO in 1998 and then crashed in 2001. Michael Jerry Saylor and Sanjeev Bansal cofounded MicroStrategy to provide custom software for companies to use in analyzing large databases. Their products were successful, and they had large corporate clients such as Kmart and NCR Corporation.

MicroStrategy's stock price told an interesting story. In June 1998, six
months before Henry Blodget's Amazon prediction, MicroStrategy did an IPO at $6 per share. The stock price went up 75 percent the first day—a huge increase, but merely average compared to other IPOs at the time. For more than a year, the stock price traded in a range of $10 to $18. Suddenly, in October 1999, the shares took off like a shot, doubling within a month and reaching $110 by mid-December. By March 2000, the peak of the Internet bubble, MicroStrategy was worth $333 per share.
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Then the stock collapsed, and by summer 2002 was back down to its IPO price of $6.

The abrupt boom and bust caused alarm bells to ring at the Securities and Exchange Commission. But interestingly, there were no sudden increases in reported profits to match the increase in stock price beginning in October 1999. Instead, MicroStrategy actually reported lower net income during the last quarter of 1999—when its stock price shot up—than in the previous quarter. Before then, net income had been increasing slowly and smoothly since 1997. In other words, MicroStrategy's stock price was being driven by factors other than simple accounting fraud. Aggressive analysts were a likely possibility, but such a theory was outside Arthur Levitt's box.

Instead, the SEC brought a simple case, arguing that MicroStrategy had been manipulating its financial statements, typically at the end of a quarter. Some of the violations were very minor. For example, MicroStrategy recognized $17.5 million of revenue from one contract for the quarter ended September 30, 1999, even though the contract was not signed until the early hours of October 1. A $5 million contract signed on January 3, 2000, was booked in the quarter ended December 31, 1999. A $1 million contract signed on April 2, 1999, was booked in the quarter ended March 31, 1999. These were minor instances of earnings management. In 2000, the SEC would have found similar problems at just about any company.

The SEC found some evidence supporting more serious allegations. Like Cendant, MicroStrategy was booking revenue upfront for service contracts that involved payments over time. In aggregate, the accounting manipulation led MicroStrategy to report gains, when in reality it was losing money throughout 1998 and 1999. The SEC enforcement attorneys had seen all this before, and the case moved quickly. By December 14, 2000, the top officers settled the case by agreeing to pay fines of $350,000 each.

Done this way, the MicroStrategy investigation, like other instances
of accounting fraud at technology firms, became an easy case. MicroStrategy's officers were lightly punished, but the SEC forced them to undertake some reforms, and it could claim yet another victory in the fight against corporate fraud. The case became another “win” to be presented to Congress when it considered the SEC's funding requests. In a related strategy, the SEC ran a series of nationwide Internet fraud “sweeps,” in which it brought enforcement actions against people who used the Internet in various fraudulent schemes.

However, as the SEC brought more simple, easy-to-prove cases, it sent two signals to corporate executives. First, blatant accounting fraud would be punished, but only lightly. The officers of MicroStrategy, like those of other technology companies involved in similar schemes, were not charged criminally, did not go to jail, and the fines they paid were insignificant compared to the fluctuations of their stock-options positions. Second, more complex fraud would likely go unpunished. Arthur Levitt had mentioned only the easiest and most common methods of fudging numbers, methods corporate executives had been using for decades. Noticeably absent from the list were schemes involving the more complex financial instruments that chairman Levitt had repeatedly ignored during his term. Sophisticated companies were using various types of swaps, as well as Special Purpose Entities and new financial instruments called credit derivatives, to take undisclosed risks and hide losses. By sending the message that the SEC was policing a handful of straightforward accounting schemes, the SEC—perhaps inadvertently—sent a message to more sophisticated firms that they could manipulate their financial statements, as long as they did it in a way that was sufficiently complex.

These more complex schemes would haunt the financial markets after the collapses of Enron and Global Crossing. But there was a hint of additional complexities in the MicroStrategy case, buried in a section of the SEC's charges labeled “Other Accounting Issues.” MicroStrategy had recognized $5 million of revenue from a deal with Sybase, Inc., in which the companies essentially swapped $5 million of software. Was it illegal for a company to record revenue from such a swap? The SEC asserted that MicroStrategy should not have recorded any revenue until it either actually used the software or sold it to another party. But how would those rules apply to other swaps, such as an agreement to deliver natural gas over a several-year period, or an agreement to exchange fiber-optic capacity over several years? In the future, such hidden arrangements would cause much greater damage to shareholders than simple accounting fraud.

Corporate executives profited from the technology boom in other ways, too. In particular, CEOs in “old-economy” businesses began buying technology companies in an attempt to increase the growth rate of their earnings. AT&T, WorldCom, Global Crossing, and others made massive investments in telecommunications infrastructure. Industrial companies—such as Enron—began shifting to an Internet platform, in an attempt to persuade investors that they, too, deserved the lofty valuations of Internet companies. Companies such as Enron also set up venture-capital subsidiaries, which they used to invest in start-up companies, just like Frank Quattrone at CS First Boston. For example, both Enron and WorldCom were major early investors in Rhythms NetConnections, which did an IPO with Salomon Brothers on April 6, 1999. One of the “lucky” investors who received shares at a price of $21 in the IPO was Bernard J. Ebbers, the CEO of WorldCom. The stock went up 229 percent the first day. WorldCom had invested $30 million and owned 8.6 percent of the company; Enron had a similar stake.
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D
uring his last years as SEC chair, Arthur Levitt tried to repair the damage done earlier, primarily by attacking accounting fraud. The SEC passed several well-intentioned measures during that time. In 1998, the SEC began requiring that financial filings be written in plain English and even published a “Plain English Handbook” on its website to help companies with grammar rules. In 1999, the SEC passed rules requiring additional disclosure and prohibiting corporate executives from intentionally misstating financial results, even if the misstatements were small—or
immaterial—
relative to the size of the company. Companies had been omitting disclosures that involved less than five percent of their revenues or earnings, calling them immaterial, but the SEC stated that “exclusive reliance on this or any percentage or numerical threshold has no basis in the accounting literature or the law.” In 2000, the SEC established Regulation FD, for “Fair Disclosure,” which prohibited companies from selectively disclosing information to securities analysts.
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According to this rule, known as “Reg FD,” if managers wanted to disclose material information, they needed to disclose it to everyone, at the same time.